3 Key Ratios To Look At When Evaluating Financial Sector Stocks – NIM, ROA And LTA

3 Key Ratios To Look At When Evaluating Financial Sector Stocks – NIM, ROA And LTA

The banks operate by accepting deposits and lending advances. Therefore, it is very important to know the spread, i.e., the difference between the interest it is receiving on advances and the interest the bank is paying on deposits to evaluate a bank’s profitability and growth. This spread is known as Net Interest Margin (NIM) which is calculated by dividing Net Interest Income by its average earning assets (including cash and balances with the RBI, advances, investments, and call money). This metric is one of the important key indicators generally used by the analysts to analyse a bank or an investment firm.

A positive NIM implies that the bank has made a wise investment decision as its interest income has exceeded the expense amount. During the increasing interest rates in the market, the cost of deposits increases and NIM gets affected. Hence, banks must transfer this cost to customers to sustain.

Example: If a bank, let’s say, Commonwealth Bank of Australia has $100 billion in deposits with a 1% annual interest rate to depositors, and it loans out $50 billion at an interest rate of 5% with earning assets of $1 billion, the net interest margin is 1.5%.

Return on assets (ROA) indicates how much profit a company is generating through its total assets. It shows how efficiently the management is using its assets to earn profits. It is calculated in percentage terms by dividing net income by total assets.

For the most accurate calculation for ROA, one should take the average of the total assets over the period he/she is considering. A 1% ROA shows that the bank is earning huge profits as they are usually highly leveraged. A high ROA is a sign of strong operational as well as financial performance.

Example: There are two banks A and B, with $1 million each in total assets. They are generating $200,000 and $300,000 respectively in net income. Therefore, their ROA will be 0.2% and 0.3% respectively. This shows that, with the same amount of Total assets, Bank B is generating more profit than Bank A, therefore, investing in Bank B is more beneficial.

The loan-to-assets (LTA) ratio is a ratio used to evaluate the risk of a bank or an investment firm. It measures the percentage of total loans outstanding with respect to total assets. A higher ratio implies that the bank has low liquidity and is highly loaned up. In simple terms, the higher the LTA ratio, the more risk the bank faces of its loans to default. LTA is derived by dividing the total assets by loans. There is no ideal loan to asset ratio. If the LTA ratio is too high, the bank may not be able to cover any unforeseen fund requirements, and if it is too low, then the bank might not be earning as much as it should be.

Example: A bank has an LTA ratio of 50%, this means that it may not able to fully utilize its assets and if it is 150% then it might be in a bad phase if the loans defaults. A ratio of 100% signifies that the bank has given a loan for every dollar of the asset (deposit) it has.


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